More Chapter 11 filings on tap for 2008

Financials, retail pain seen spreading to industrial sector

By

LauraMandaro

SAN FRANCISCO (MarketWatch) - Market analysts warn that more U.S. businesses are likely to hang "going bankrupt" signs on their doors next year as the twinned blows of slower economic growth and pricey commodities force the weakest companies to seek refuge from creditors.

In a twist from this year's trends, the pain is likely to spread from mortgage lenders, homebuilders and consumer-oriented firms - all areas that contributed to a 40% jump in bankruptcy filings in 2007 and are expected to play a role in 2008's misery.

Next year, industries at risk for the biggest increases in Chapter 11 filings include electronics makers, energy miners like coal companies and agriculture firms, according to Global Insight.

Makers of durable goods like machinery are also more at risk and will likely contribute to a 13% rise in bankruptcies in 2008, says the private research firm, which bases its estimates on issuers' credit quality and operating conditions.

Some of the reasons? "Slowing growth, particularly in the United States, increasing supply pressures, increasing production in China," lists Global Insight managing director Mark Killion.

The bond market has been placing its own bets on which companies are more in danger of squelching on their debt. These run the gamut from brokerages singed by the subprime crisis; paper and chemical companies struggling with industry downcycles; and a motley assortment of media and entertainment companies.

Online broker and bank E-Trade Financial Corp.
ETFC, +0.41%
PVC pipe-maker Georgia Gulf Corp.
GGC, -10.24%
and newsprint maker Bowater Inc. (now part of AbitibiBowater Inc.
AB.H, +0.00%
) - these are some of the companies Standard & Poor's says carry debt that qualifies as "distressed" because the companies have speculative grade ratings and their bonds have been trading at least 1,000 basis points over Treasuries. That spread indicates investors want more payback for taking on higher risk.

The portion of issuers that qualify as distressed, which include Remington shavers and consumer products conglomerate Spectrum Brands Inc.
SPC, -1.15%
mortgage lender Residential Capital LLC and theme-park operator Six Flags Inc.
SIX, +0.24%
has climbed to about two-year highs. Companies that sell to the consumer make the biggest part.

On the macro front, new bankruptcy risk to makers of such goods as electronics and heavy equipment comes from an expected slowdown, or even recession, in the United States next year. For raw materials producers, say metals makers, that slowdown risk is combined with supply competition from new industrial juggernaut China.

Meanwhile rising raw material prices, from fuel to metals to grains, have raised cost pressures for makers of equipment and even some high-flying commodities producers.

"Outside of oil, whatever the ability there is to raise prices, the fact is that input prices are going up at a similar rate," said Killion.

In the past few months, General Electric Co.
GE, +1.08%
U.S. Steel Corp.
X, -3.17%
Newmont Mining Corp.
NEM, -2.92%
and every major domestic airline have warned that rising raw material prices were cutting into profits.

The U.S. government's wholesale price index in November jumped to its highest level since 1973, as energy prices surged over 14%. Crude-oil futures have risen about 45% in the last year, coal prices have gained 32% and soybeans - the basis for many prepared food products -- are up a whopping 80%.

Meanwhile, analysts anticipate more companies in industries linked to housing will file for bankruptcy or follow the increasingly popular course of opting to sell their assets to a restructuring firm and then declare themselves out of business.

"Homebuilders will continue to be on the edge," predicted Reginald Jackson, president of the American Bankruptcy Institute and a bankruptcy attorney at Vorys, Sater, Seymour and Pease LLP in Columbus, Ohio.

Of course, most of the large, public firms in vulnerable sectors are far from the bankruptcy brink. But in those same industries, weaker companies might find the dual pressures of slowing revenues and high costs the final straw.

That was the story in 2007.

As mortgage defaults and tight credit soured conditions for many financial firms, and consumer companies struggled against the headwinds of slowing labor markets and high gasoline prices, it was the companies with the shakiest or riskiest business profiles that took the Chapter 11 route to bankruptcy.

Going bust were mortgage lenders like New Century Financial Corp.
NEWCQ
and ResMae Mortgage Corp, loss-making retailers like Tweeter Home Entertainment Group
TWTRQ
and Bombay Co.
BBAO
and restaurant chains like Specialty Restaurant Group and The Roadhouse Grill. Not surprisingly, a slew of homebuilders, including Levitt & Sons, a unit of Levitt Corp.
LEV, +1.97%
also filed for court protection from their debtors.

Those filings lifted the number of U.S. corporate bankruptcies from a record low in 2006 to an estimated 27,499 in 2007.

Foreshadowing of more pain is playing out in the bond market, where ratings agencies are slashing credit outlooks to levels where, historically, the risk of default has been high.

Standard & Poor's counted consumer products as the global sector with the highest risk of a defaulting on their credits, followed by retail/restaurants, and media and entertainment. Most of these are in the United States. Forest products, fourth on the list, had the most defaults in the United States during the 12 months until November.

Companies in these sectors have more ratings of B- or lower as well as credit watch negative or negative outlooks assigned by Standard & Poor's.

"We think of those companies as being on a slippery slope with the potential to go into default," said Diane Vazza, head of global fixed income research at Standard & Poor's.

In general, default rates for riskiest borrowers are expected to rise. Standard & Poor's estimates 56 speculative debt issuers will default in the next 12 months, a rate of 3.4% compared with less than 1% this year. The term "speculative" refers to the riskier borrowers whose debt falls below investment grade and is often called junk.

Moody's Investors Service, for its part, anticipates the default rate to rise to 4.7% over the next 12 months.

Of course, defaults don't necessarily lead to bankruptcies or liquidations. Some companies manage to get a time-out from bank lenders and bond holders, or refinance their heavy debt loads. But refinancing is increasingly tricky as brokerages find it harder to sell high-risk debt to investors and banks tighten lending standards.

The ability of wobbly borrowers to obtain new financing has become a lot more difficult in the last year, says bankruptcy lawyer Jackson. That credit squeeze means more companies are spending less time in bankruptcy and are instead finding quicker exits via liquidation or sales.

"There's more using Chapter 11 as a way to realize the value of a company and its assets through a sales process," said Jackson.

How to play the trend

For retail investors, a pending bankruptcy in an investment usual translates to "sell that stock." Institutional investors, however, have found ways to make money off these corporate crises, and some mutual funds allow individual investors to follow along.

These include Martin Whitman's Third Avenue Value Fund
TAVFX, +0.61%
some of Franklin Templeton's Mutual Series funds and the Wintergreen Fund
WGRNX, +0.74%
managed by value investor David Winters.

Some funds hunt for stocks that managers think are trading at a deep discount. Some buy bonds trading for cents on the dollar before or while the bankrupt company restructures. Since bondholders rank high among parties with claims on the assets of a bankrupt company, those bonds are often worth more when the company exits bankruptcy.

Some fund managers even get involved in the bankruptcy process. Last year, Third Avenue objected to the fees charged by lawyers in the reorganization of auto supplier Collins & Aikman Corp. when it owned bonds in the company.

"We're seeing a lot of companies come under duress," said Russ Kinnel, director of mutual fund research for Morningstar, Inc. "Often when there's a lot of fear, that creates opportunity," he said.

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